What is an Inflation Swap
An inflation swap is a contract used to transfer inflation risk from one party to another through an exchange of cash flows. In an inflation swap, one party pays a fixed rate cash flow on a notional principal amount while the other party pays a floating rate linked to an inflation index, such as the Consumer Price Index (CPI). The party paying the floating rate pays the inflation adjusted rate multiplied by the notional principal amount. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap.
BREAKING DOWN Inflation Swap
Inflation swaps are used by financial professionals to mitigate (hedge) the risk of inflation and to use the price fluctuations to their advantage.
As with interest rate swaps, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged), but instead of hedging against or speculating on interest rate risk they are concerned with inflation.
Many types of institutions find inflation swaps to be valuable tools. Payers of inflation are typically institutions that receive inflation cash flows as their core line of business.A good example might be a utility company because its income is linked (either explicitly or implicitly) to inflation.
How an Inflation Swap Works
As with other swaps, an inflation swap initially values at par. As interest and inflation rates change, the value of the swap's outstanding floating payments will change to be either positive or negative. At predetermined times, the market value of the swap is calculated. A counterparty will post collateral to the other party and vice versa depending on the value of the swap.
In the case of zero-coupon swaps, there are no cash flows paid until the maturity of the swap contract.
An example of an inflation swap would be an investor purchasing commercial paper. At the same time, the investor enters into an inflation swap contract receiving a fixed rate and pays a floating rate linked to inflation. By entering into an inflation swap, the investor effectively turns the inflation component of the commercial paper from floating to fixed. The commercial paper gives the investor real LIBOR plus credit spread and a floating inflation rate, which the investor exchanges for a fixed rate with a counterparty.